The Company Act 2006: Promoting Corporate Governance and Protecting Minority Shareholders - Assignment Example

?The Company Act 2006: Promoting Corporate Governance and Protecting Minority Shareholders The recession that has hit much of Europe and America and the widely-reported corporate scandals have highlighted the need to make corporate governance at the top of a company’s order of priorities and the overriding principle guiding its directors. The escalating protests in Wall Street in the United States demonstrate growing public outrage against corporate greed and white-collared crimes. Indeed, instead of mere wealth generation for shareholders, the underlying principle that should inform decision-making processes of corporations should be the improvement of corporate governance and addressing elite deviance. This paper will explore two specific areas of corporate governance and how the Company Act 2006 is presently addressing it. The first is through granting more rights to minority shareholders to bring suit against majority shareholders for prejudicial business decisions and making these rights meaningful in practice and not just on paper. The second is creating more measures against opportunistic and predatory directors to exact responsibility and accountability for fraud. It is hoped that by examining the corners of the policy framework of covering these areas, this paper surfaces issues that need to be addressed and prioritised, thereby proving the necessity of establishing corporate governance as first order of the day before simple wealth generation and maximisation. Legal Framework: Company Act of 2006 The legal framework in place is the UK Company Act of 2006. The major purposes underlying the UK’s Company Act of 2006 is to protect shareholder rights, to ensure directors’ responsibility, to promote corporate governance – all of which will, in the end, facilitate a better policy environment for commerce and trade. The Companies Act – previously known as the Company Law Reform Bill -- received its second reading in the House of Lords on January 11, 2006, and received Royal Assent on November 8, 2006. As stated by Lord Sainsbury, Parliamentary Under-Secretary of State at DTI, the purpose of the Act is to “to constantly update company law in response to changes in the way companies do business”1. According to Lord Sainsbury, the Act has four key objectives: Enhancing shareholder engagement and a long-term investment culture Ensuring better regulation and a “think small first” approach Making it easier to set up and run a company Providing flexibility for the future. Protection of Minority Shareholder Rights: Revisiting the rule in Foss v. Harbottle It cannot be gainsaid that minority shareholders occupy a vulnerable and precarious position in the hierarchy of the corporate structure. The dilemma that of how one is to go about preserving their rights and granting them protections is akin to the dilemma that faces a democratic polity: while the will of the majority is a foremost consideration and indeed is the most equitable way to resolve disputes and frame policies, there is an equally compelling and equally valid need to have regard for the interests of those in the minority – marginalized sectors who face constant threat of being disenfranchised in a system founded on justice and fairness. The part of the Act that is most relevant to shareholder engagement is Part 11, which provides shareholders with, as stated in paragraph 480 of the Explanatory Notes, “a new procedure for bringing such an action which set down criteria for the court distilled from the Foss v Harbottle jurisprudence". 2 The Act essentially expands the existing derivative action, and allows shareholders to sue the directors for a wider range of breaches, namely in respect of an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust. Another significant change is that a shareholder who has brought proceedings must apply to court for permission to continue the claim. The Act also contains restrictive provisions on the issue of ratification by the majority. Members who are personally interested in the ratification or who stand to gain from it will not be allowed to vote, when such ratification involves a director’s negligence, default, breach of duty or breach of trust. The consequence of this is that it will now become easier for shareholders to obtain permission to continue a derivative action. If leave of court is granted, the company must reimburse the shareholder for the costs of litigation. This is a response to the celebrated Foss v. Harbottle decision3 , recognized not only in the United Kingdom but in other jurisdictions as well. In this particular case, two minority shareholders initiated legal proceedings against the directors of the company, for misapplying corporate assets. The court dismissed the claim, saying that it is only the company that has standing to sue, and laid down the landmark rule, also known as “proper plaintiff rule”. It can be argued that there are justifications for this “notoriously-difficult”4 rule, and they may be considered separate principles in themselves. This is supposedly also to lessen vexatious litigation instigated by disgruntled minority stockholders to oppose policies laid down by management in the exercise of its discretion, and to prevent companies from being torn apart by litigation5. In a contract, parties have mutual obligations, and by buying shares in a given company, stockholders undertake to abide by policies made by the Board of Directors in the exercise of their discretion. This suggests that disputes should always be dealt with first using the internal machinery of the company. This principle is consistent with the notion that those who voluntarily take the position of directors and invite confidence in that relation, undertake that they possess at least ordinary knowledge and skill and that they will use them in the discharge of their functions as such. Says Prentice6: The rule in Foss v. Harbottle can be stated with disarming simplicity. Basically, there are two branches to the rule. First, “the proper plaintiff principle”, which provides that in any action asserting rights inhering in a company, the proper plaintiff is the company itself, and secondly, the “internal management principle”, whereby the courts will not interfere with the internal management of companies acting within their powers.” Concededly, the rule in Foss v. Harbottle is subject to a number of exceptions. All legal scholars of Company Law acknowledge that “if there were no exceptions to this pragmatic rule, which reinforces the rule of the majority in corporate control, minority shareholders would ever be at their mercy.”7 An important one “fraud on the minority.” In this case, it is no longer necessary for a majority to approve litigation because the parties who perpetrated the fraud could attempt, through simple show of hands to stop the litigation. A “fraud on the minority” would relax the rule in Foss v. Harbottle that a majority must approve the litigation because in this particular situation, the fraudulent parties, by the simple expedient of exercising the will of majority, can undermine or prevent a plainly just and equitable course of action. As Browne-Wilkinson LJ said in Nurcombe v Nurcombe 8, “Since the wrong complained of is a wrong to the company, not to the shareholder, in the ordinary way the only competent plaintiff in an action to redress the wrong would be the company itself. But, where such a technicality would lead to manifest injustice, the courts of equity permitted a person interested to bring an action to enforce the company’s claim.” “Fraud on the minority” involves two elements. The first is a cause of action in the company that can be characterised as an equitable fraud. Fraud includes all cases where the wrongdoers are endeavouring, directly or indirectly to appropriate themselves money, property or advantages which belong to the company or in which the other shareholders are entitled to participate, according to Burland v. Earle9 . The second element is control of the company by the wrongdoers. Under the U.K. company law, the court has broad discretion to make remedial orders if there has been unfairly prejudicial conduct (including orders to regulate corporate conduct or purchase a shareholder's stock)10. The main problem is that though there has been a considerable liberalization of the concept, and it has been comparably easier for minority shareholders to seek redress for the oppressive conduct of majority shareholders, many legal thinkers maintain that the legal climate in the United Kingdom is still weak in regulating such forms of corporate oppression. While in the US the market for corporate control, manifest in takeovers, provides a powerful incentive towards good corporate governance, these mechanisms have remained weak in the UK.11 While it was able to somewhat address the rigidity and inflexibility of the Foss v. Harbottle doctrine, there still were some gaps and holes that needed to be filled. For example, the linkage with winding up claims posed as a major roadblock to the right of minority shareholders to seek redress. Another problem was that minority shareholders needed to prove that the conduct was oppressive. According to the case of Scottish CWS v. Mayer,12, this meant “burdensome, harsh and wrongful”. What this succeeded in doing was set a very high threshold, making it nearly impossible for minority shareholders to initiate a suit against the majority. S75 CA 1980 amended the law by providing answers to the questions raised by s210. Most significantly, it removed the link with winding up petitions. S459 amended it even further, and its most substantial contribution is that it lowered the threshold. A plaintiff no longer has to prove “oppression”. Rather, he only needs to prove “unfair prejudice”13. It must be noted, however, that an s459 remedy is not the same as a derivative suit. Said Reisberg14, “the unclear interaction between the two remedies projects an uneasy shadow, which in turn affects the viability of derivative actions.” The rather confusing panoply of laws is perhaps best reflected in Lord Hansard’s statement, “Many have argued that Clause 239, rather than mirroring the common law as the Government claim, in fact goes further. The common law is uncertain. These provisions have not been much used and the outcomes have sometimes been conflicting, so it is hard to specify exactly what the current position is.” It makes the rules pertaining to minority shareholder rights quite complex and may discourage minority shareholders from availing this right. Ensuring Directors Responsibility The first part deals with minority rights to object to company policies that they feel prejudice them. The second part deals with exacting responsibility and accountability from directors who, so to speak, get caught with their hands in the cookie jar. In theory, a director, holding as he does a position of trust, is a fiduciary of the corporation. As such, in cases of conflict of his interest with those of the corporation, he cannot sacrifice the latter without incurring liability for his disloyal act. The fiduciary duty has many ramifications, and the possible conflict of interest situations are almost limitless, each possibility posing different problems. There will be cases where a breach of trust is clear, as where a director converts for his own use funds or property belonging to the corporation, or accepts material benefits for exercising his powers in favor of someone seeking to do business with the corporation. In many other cases, however, the line of demarcation between the fiduciary relationship and a director’s personal right is not easy to define. What is clear, however, is that shareholder conflicts are prevalent in virtually all jurisdictions and the law has to formulate appropriate channels of redress in order to resolve these conflicts. As Miller15 said, it is one of the most common reasons in the world for people to go to court. There is no surfeit of examples to demonstrate how minority shareholders and their interests can be prejudiced by the director or those with controlling interests in the corporation. One of the most typical situations of self-dealing is the fixing of directors’ and officers’ compensation. This may take various forms – per diems, salaries and profit-sharing arrangements like bonuses, stock option plans, and the like. Executive compensation in the United Kingdom is typically comprised of the following elements: a base salary, an annual bonus element, and long term pay. Long term pay consists of share options and long-term incentive plans. (Conyon, Peck, Reed, Sadler. 480). In other jurisdictions, as a general principle, directors as such are not entitled to compensation for performing services ordinarily attached to their office, unless the articles of association or the by-laws expressly so provide or a contract is expressly made in advance. In theory, compensation to executives and employees are incentives to greater efficiency. Since the corporation ultimately benefits by this increased efficiency, such forms of compensation would be intra vires, and the fixing of the amount thereof would usually be within the business judgment of the directors. However, abuses may arise where the executives concerned are at the same time directors of the corporation, or have a dominating influence over them. Said Conyon, Gregg and Machin16, “Much of the evidence from empirical work on the determinants of compensation received by top executives has concluded that there is only a very weak statistical link between direct compensation (ie., excluding shareholdings and options) and the market performance of their companies.” What this tends to demonstrate is that errant directors will continue to give themselves lavish salaries and allowances, regardless of profits of the corporations; whilst ordinary shareholders reap benefits only when the corporation profits. But how then do we ensure a focus on corporate governance rather than maximisation of wealth? To quote Demott17: A central question that underlies many analyses of corporate governance is whether the law and legal institutions have a constituent role in shaping governance practices, or whether the law, as well as governance practices, are best viewed as the inevitable results of market forces, centered upon capital markets. A separate, but related question, is the degree to which mechanisms of governance – such as shareholder voting, take-over bids, independent directors, mandatory disclosure, and shareholder litigation – can function adequately as substitutes for one another. The move to develop the notion of corporate governance and make it apply to corporate enterprises in the United Kingdom began in the late 1980s to the early 1990s, as a result of corporate scandals like Polly Peck and Maxwell. The idea of corporate governance is rooted in the idea of agency. Those who infuse capital into a business enterprise hire managers to run the business for them and see to its day to day affairs. The board of directors and the institutional investors also play a role in the monitoring and control of firms. However, the relationships of these players – to each other and to the general public -- must not be left alone and unregulated. It is imperative that there be well-established rules for companies to follow as they navigate the course of the growth. In a company, virtually all policy-making is left in the hands of the Board of Directors or on the majority shareholders. While allowing directors to control business strategies has merit – for instance, decision-making is streamlined and businesses largely depend on the need to be able to respond to issues not only with soundness but also with dispatch -- some problems inevitably arise. Instead of prioritising simple wealth generation, efforts must be undertaken towards stricter corporate governance. The desire to ensure the stability of business and protect commerce in the United Kingdom should be balanced by the equally-compelling need to protect the rights of minority shareholders. Though legal and economic conceptions have both rested on and have been shaped by the normative implications of ownership18, it should also be animated by equity and corporate responsibility. For indeed, if what is sought in the long-term is a robust commercial system supported by a legal regime that protects rights, accommodates as many players as possible and will not countenance fraud or breach of duty of those wielding power, then wealth generation will simply not be enough – ensuring the long-term sustainability of the company by an adequate and accountable corporate governance framework is key. WORD COUNT: 3018 References Barak, Aharon. “A Comparative Look at Protection of the Shareholders' Interest: Variations on the Derivative Suit.” International and Comparative Law Quarterly, Vol. 20, No. 1971), pp. 22 57. Blake, A. and Bond, H., Company Law, London, Blackstone, (1993) 4th Ed. Boyle, A.J. Minority Shareholders’ Remedies. Cambridge University Press. 2002. 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